Defense cuts could sink this stock

Commentary: Economic, political headwinds make it hard to like L-3

BOSTON (MarketWatch) — It’s a common for market analysts to speculate about which stocks might benefit or be hurt based on the presidential election’s outcome.

One stock where the gulf of opinion seems as wide as the differences between Democrats and Republicans is L-3 Communications Holdings Inc. While some observers believe defense contractor L-3
LLL, -0.34%
could benefit from the election, the likelihood of military spending cuts and other pressures make the stock the Stupid Investment of the Week.

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Stupid Investment of the Week highlights the conditions and characteristics that make a security less than ideal for the average investor, and is written in the hope that spotlighting danger in one case will make it easier to sidestep trouble elsewhere. While obviously not a purchase recommendation, the column is not intended to be an automatic sell signal, particularly in a case like L-3 where there is a wide range of analyst opinions on the stock.

For instance, TheStreet Ratings recently upgraded the stock, while Zacks Investment Research downgraded it to a sell, showing the kind of disagreement on the shares that seems common. L-3 could climb that proverbial wall of worry and disagreement, but the bigger problem is that its business environment does not look hospitable no matter who wins the White House.Read more: 5 Obama, 5 Romney stocks for voters’ portfolios.

In fact, the disagreement is a bit like a political campaign, in that supporters and detractors are approaching L-3 from different angles. Buyers are looking at the company from the bottom up, while the view is completely different from the top-down.

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L-3 Communications supplies a wide range of products and services used for aerospace and defense platforms. The company in July completed the spin-off of its government-services unit, called Engility Holdings
EGL, -2.42%
and in August purchased Thales Training & Simulation Ltd.’s civil aircraft training business, showing that while the company is making the transition to a slow-growth stock, it’s not done improving business through acquisition.

The case for buying the stock is compelling, especially for investors who believe that certain numbers never lie.

L-3 Communications currently trades at a discount to both its peer group and the Standard & Poor’s 500 Index
SPX, -0.44%
. You can look at the numbers and forecast that, under ideal circumstances, the stock could be worth as much as $120 per share. The shares closed at $73.20 on Monday.

Good company, bad stock

While the levels of debt and goodwill might make some balance-sheet watchers nervous, L-3 passes all of the tests for being a “good company,” but that doesn’t necessarily make it a “good stock.”

Interestingly, the company’s second-quarter earnings per share and net sales both were down from a year ago, but were above analysts’ consensus estimates, according to Zacks Investment Research, highlighting the idea that the many observers are expecting better from L-3 than it is actually delivering,

Brent Wilsey of Wilsey Asset Management in San Diego, Calif. noted that L-3 looks “like it’s doing almost everything right, and if I buy good businesses at good prices, I can hold them for three to five years and wait for the investment to pay off.”

The problem for investors is that when good companies go through periods where they are bad stocks, it’s often hard to stick around for the ride.

L-3 is facing significant headwinds. Defense-spending cuts pose a potential problem for a lot of companies, but particularly L-3 because it has typically focused more on short, fast government contracts than many of its competitors. In fact, the company’s discounted valuation may be due, in part, to the focus on the shorter-cycle, because Wall Street would rather see a longer, deeper pipeline of future business.

L-3 must replenish those expiring contracts with new business at a time when most expectations are for defense spending to start to dry up. While L-3 is a maturing business, it is still smaller than many of its rivals; those companies will also look to maintain top-line revenues during a governmental belt-tightening; with heightened competition, typically, comes reduced profit margins.

If future growth rides on the company’s ability to replace the existing contracts with new ones, just at a time when it will be tougher than ever to secure that business — and that is precisely what will determine L-3’s future — then the stock’s uncertainty factor goes way up.

While analysts argue as to whether the macro concerns are already priced into L-3 shares and talk about potential top values well above $100 per share, most acknowledge that a fair-market value for the stock is closer to the $65 range.

Thus, while L-3 is cheap relative to its peer group and the broad market, it’s pricey compared to its own market value.

That’s the kind of situation that creates downside risk — and increases the potential for headlines about defense cuts to send shares below fair-market value. Such volatility prompts many investors to bail out before they achieve the best-case picture that the fundamentals are painting.

Said Wilsey: “Long-term, this is the kind of business people can be comfortable owning, but only if you can ride out the storms that might happen with the politics.”

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